Preparing for Manic Monday

U.S. equity market futures are currently down nearly 2%. Markets across the Middle east sold off earlier, while Asian and European markets looked poised for similar declines. An exaggerated sense of uncertainty is affecting markets even before the true effects of a U.S. sovereign downgrade are known. For many individuals in the investment world, this weekend was likely very busy as investors and asset managers tried to assess the potential consequences and create a game plan moving forward. Much of my weekend was spent in this fashion so I’ll try to lay out the possible repercussions of the U.S. credit rating downgrade and thoughts on how to invest around it.

As surely everyone is aware by this time, Standard and Poor’s (S&P) downgraded the U.S. credit rating from AAA to AA+ on Friday evening. Potential ramifications are beyond complete comprehension, making it relatively easier to think of possibilities within simplified categories. In this sense the following discussion will focus on treasury debt, U.S. dollar exchange rates, states/municipalities, banks/GSEs, money market funds, investment funds and international markets.

Treasury Debt
To many individuals, the most obvious response to the credit downgrade should be a decrease in price of U.S. debt and corresponding increase in yields. While I expect a quick sell off when markets open tomorrow, buyers may soon after swarm the market searching for yield. Despite the downgrade, treasuries still represent the largest and most liquid asset in the world. With most of the developed world experiencing an economic slowdown and increasing risk of disinflation (possibly, deflation), long-term treasuries still represent a safe, solid investment. Maintaining the expectation that 30-year treasury yields will fall to 3% within the next 5 years, entry points above 4% remain ideal.

U.S. Dollar
Similar to treasuries, most individuals are probably expecting weakness in the dollar. When currency markets opened this afternoon, the dollar was substantially weaker against most currencies, including the euro and yen. However, when U.S. equity futures opened down sharply, the U.S. dollar rallied back. Regardless of the U.S. credit rating, no other currency options currently exist to replace the dollar as the world’s reserve currency. Tonight, the G-7 vowed to provide liquidity and ensure against disorderly variations in currency exchange rates. Since exchange rates naturally reflect movements of one currency against another, it’s unclear which currencies they will aim to support and at what levels. Either way, central planning is unlikely to be successful for very long. Equity market weakness and increasing fears of deteriorating economic growth will likely push the dollar higher in the coming week.

States and Municipalities
Moving into secondary effects of the rating downgrade is where making judgments becomes far more troublesome. Acknowledging the financial support and backing provided by the federal government to states and localities, many of these entities will likely face downgrades starting tomorrow. While treasuries may be exempt from AAA requirements at various investment funds, it’s unclear whether state and local government debt is treated similarly. Either way, the recent debt limit agreement has made it clear that state government funding will not be increased going forward. Already under budgetary pressure, a number of states and municipalities may face higher interest rates and worsening financial conditions.

Banks and GSEs
Possible outcomes become really interesting in this sector as ratings of several firms are almost certain to be negatively impacted. Many American banks, as well as the GSEs (Fannie Mae, Freddie Mac), currently enjoy somewhat higher credit ratings because of the belief that the federal government would once again bail out debt investors, if necessary. However, S&P notes the following negative consideration in their Sovereign Government Rating Methodology And Assumptions:

“Contingent liabilities refer to obligations that have the potential to become government debt or more broadly affect a government's credit standing, if they were to materialize. Some of these liabilities may be difficult to identify and measure, but they can generally be grouped in three broad categories:

· Contingent liabilities related to the financial sector (public and private bank and non-bank financial institutions);

· Contingent liabilities related to nonfinancial public sector enterprises (NFPEs); and

· Guarantees and other off-budget and contingent liabilities.”

Given recent plans to cut federal spending and potential fear of further downgrades, the willingness to bail out these institutions going forward may be reduced. Ratings downgrades for these firms could result in higher capital requirements and some potential forced selling of assets. Already witnessing heavy selling in equity markets the past couple weeks, the pressure may become even more pronounced in the days ahead.

Money Market Funds
Although the long term credit rating of the U.S. was downgraded, the short term rating retained the highest ranking. Treasuries therefore seem unlikely to create any holding issues for these funds. Potential problems could arise if the short term ratings of other investments in bank or GSE paper is downgraded. However, this currently appears to be an area of minimal concern.

Investment Funds
Leading up to the recent market sell off, margin debt on the NYSE was near record highs and cash holdings by mutual funds were near record lows. Investment funds, in general, appear to have been heavily leveraged on the long side after witnessing nearly two years of upwards markets with small pullbacks. Over the past eleven trading days global equity markets fell significantly, with several down over 10%. Further declines could spark margin calls, resulting in forced selling. These circumstances have potential to spiral quickly out of control and feed on themselves in a vicious cycle.

The other primary fear for investment funds stems from potential bylaws requiring a funds’ holdings maintain certain average credit ratings or a specified percentage in AAA-rated securities. Strict bylaws with these constraints have potential to cause forced selling of securities. Many investors have argued that since only S&P downgraded the U.S., bylaws would not be broken (two of three still rate U.S. AAA). Although this may be true, the potential for Fitch or Moody’s to follow suit in downgrading the U.S. (regardless of recent actions) seems fairly high. Asset managers may therefore find it prudent to sell certain holdings in advance of any potential forced selling later on.

International Markets
Recognizing added uncertainty over the coming week, odds seem high that international equity markets will continue selling off. Last week Japan and Switzerland intervened in markets attempting to weaken their respective currencies. The U.S. rating downgrade may increase pressure on those safe-haven currencies again and force further government intervention. Japan, especially, can ill afford an ever stronger yen and maintain hopes of an economic recovery.

Although most discussion within the U.S. has focused on the rating downgrade, some very important news has come out of Europe this weekend. Earlier today Germany says eurozone can't save Italy. In EU Steps Forward, Still Much More Needed, I explained that using the EFSF to support Spain and Italy would require Germany to accept an absurd amount of liability, especially if France were no longer rated AAA. Well, comparing the U.S. and France across many of S&P’s metrics, it appears that downgrade may not be far off. Without France’s AAA rating, the EFSF would be unable to maintain its AAA rating, throwing the whole bailout mechanism into question. Tonight the ECB announced it will purchase Spanish and Italian sovereign debt to stem the crisis. Although they should be commended for following the poem, “if at first you don’t succeed, try, try, try again,” this attempt seems equally doomed to failure. As markets move further into risk-off territory, Europe’s crisis may become increasingly untenable.

Actionable Advice
When I was an options market maker, during times of extreme uncertainty and volatility we always widened out prices. For investors I’d recommend setting limit orders with an extra margin of safety to protect against further downside but take advantage of large moves that present incredible opportunities. While I was certainly bearish on equities with the S&P above 1300, I’m increasingly more constructive in the 1100’s. Over the past two years the market has been led by several high flying stocks that now support price-to-earnings ratios in the stratosphere. Beneath the surface remains numerous securities offering significant yields at reasonable prices. Investors who are currently underweight equities should therefore look to add exposure on further pullbacks.

In spite of its weaknesses, the U.S. remains the most dynamic economy and global safe-haven. Recognition of a global economic slowdown, now recognized, will likely further pressure equity markets to the downside. Europe’s problems continue to worsen with no valid remedy in sight. Japan’s pattern of recurring recessions and deflation continues unabated. China faces prospects of a hard landing as it tries to reign in inflation. As astonishing as it seems, the uncertainty caused by the U.S. downgrade may actually create strength for treasuries and the dollar. For those prepared investors, heightened uncertainty generates the greatest investing opportunities. Get ready for an exciting week!

Reflecting on Rating Downgrade

On Friday night, for the first time in 70 years, Standard and Poor’s (S&P) downgraded the sovereign credit rating of the United States from AAA to AA+. News of the potential downgrade was leaked Friday morning spurring much discussion on Twitter. Friday afternoon it became clear the Treasury, Administration and Congress had been notified of the impending downgrade and seemingly allowed a rebuttal. Since the official announcement, nearly all financial discussion has focused on the uncertain consequences and baffling decision by S&P. Later today I hope to provide some commentary on the possible repercussions of the downgrade, but for now I actually want to take a moment to defend S&P when seemingly nobody else will.

Before placing judgment on the ensuing discussion, please recognize that I do not believe S&P or the other Nationally Recognized Statistical Rating Organizations (NRSRO) are deserving of the legitimacy and power assigned to their credit ratings. Relying on payments from issuers of bonds creates a severe conflict of interest that most notably hurt investors during the widespread misrepresentation of credit risk on mortgage backed securities and other structured finance products. However, many of the current criticisms appear to reflect either a misunderstanding of credit ratings or failure to read S&P’s Sovereign Government Rating Methodology And Assumptions.

“Standard & Poor's credit ratings express a relative ranking of creditworthiness” that is primarily free information available to individuals. It’s important to remember that any credit rating is merely the opinion of an independent company. A credit rating may aid an investor in valuing a bond, but should never replace actual due diligence in determining his/her own opinion on an issuer’s creditworthiness. Since credit ratings represent an opinion, I have no qualms against anyone stating their disagreement with S&P’s view. My urge to write this piece is against those commentators claiming, in various forms, that S&P holds no right to have an opinion. These complaints seem childish and perpetuate many of the political weaknesses noted in the downgrade. Ultimately the decision at S&P was made by a group of individuals with similar rights to an opinion on the creditworthiness of the U.S. as anyone else. Going forward I hope discussions will focus on disagreements in rating methodology or the use of credit ratings and not on who deserves an opinion.

Apart from frustration at S&P stating their opinion, a greater proportion of recent discussion seems focused on displaying disgust towards S&P’s rating methodology. While I certainly don’t believe S&P’s sovereign rating system is flawless (if that were even possible), potential errors do not appear as glaring as many have opined. Although the $2 trillion mathematical error sounds bad, the reality is that amount makes little difference in the long-term outlook or reasons cited by S&P for the downgrade.

One frequent objection that stands out is the claim that S&P should not make qualitative judgments regarding the creditworthiness of the U.S. A number of highly educated people have even appeared surprised by this notion. From S&P’s website (emphasis mine): 

THE BASICS OF SOVEREIGN RATINGS

Standard & Poor's appraisal of each sovereign's overall creditworthiness focuses on political and economic risks and is both quantitative and qualitative. The quantitative aspects of the analysis incorporate a number of measures of economic performance, although judging the integrity of the data is a more qualitative matter. The analysis is also qualitative due to the importance of political and policy developments and because Standard & Poor's ratings indicate future debt-service capacity.

Clearly S&P has not hidden the fact it makes qualitative judgments and I can only assume this basic statement has been available to the public for years, if not decades. Sudden outrage certainly seems misplaced.

Beyond the fact that S&P uses qualitative measures, the question remains whether or not this practice is valid. To address this issue it’s imperative that the meaning of a sovereign credit rating is clear. From S&P’s Sovereign Government Rating Methodology And Assumptions (emphasis mine):

“All references to sovereign ratings in this article pertain to a sovereign's ability and willingness to service financial obligations to nonofficial, in other words commercial, creditors.”

Ability and willingness are highlighted since they represent the similar dichotomy between quantitative and qualitative. As I’ve stated in previous posts, the U.S. is a currency issuer with debt denominated in its own currency and therefore never faces an inability to pay. Laws, such as the debt limit, reflect self-imposed constraints on the country’s willingness to pay. Fathoming ways to quantify future Congress’ willingness to pay is quite difficult. The reality is that U.S. debt currently only faces default risk related to willingness to pay and that risk is by nature qualitative. Therefore, ignoring qualitative measures would be equivalent to disregarding the possibility that Congress could ever choose to default (and has happened before).

The first downgrade in history has now occurred, which makes it time to address and deal with the consequences. From my perspective, too much time has already been spent degrading S&P and complaining about the decision. If investor’s opinions differ from S&P, than any related sell off in treasuries should provide a nice buying opportunity. If people believe credit ratings are used by investors inappropriately, then they should work to increase education and improve dialogue on the matter. If Congress believes S&P’s critiques were out of line, then they should prove an unbound willingness to pay by removing self-imposed restraints such as the debt limit.

Ten days ago President Obama said the following in a speech on the debt ceiling:

Now we have a AA+ credit rating, to match our (at best) AA+ political system. S&P’s credit rating downgrade only confirmed this belief that most already held. Less time should be spent demonizing S&P and more time focused on rebuilding a AAA political system. When that day comes, I have a feeling the credit rating will also display AAA.

Betting on a Stronger Dollar

Earlier this week the U.S. dollar nearly reached a new all-time low against the Japanese yen. Unable to hold out any longer, the Bank of Japan (BOJ) intervened in the currency markets, buying dollars and selling yen. Except for during recent recessions, the dollar’s exchange value has been falling against most other major currencies for the past decade. Effects of and reasons for currency devaluation are frequently misunderstood and therefore it’s imperative to shed light on the fluctuating valuations.

When discussing money and currency, an initial point to highlight comes from The Theory of Money and Credit by Ludwig von Mises. Mises notes that fiat currency has no value apart from acting as a means of exchanging goods. A currency exchange rate, at its most fundamental level, is therefore merely the reflection of differing monetary values of goods between nations. Attempting to quantify rates of exchange between nations, economics created a purchasing power parity (PPP) exchange rate.

Understanding the rise of the yen, by Scott Grannis of Calafia Beach Pundit, highlights the diverging dollar/yen exchange rate from a theoretical PPP (shown below). 

At first glance one notices that the yen is approaching levels of significant historical and relative strength. However, before addressing the yen’s strength, some discussion is necessary to explain the PPP’s longstanding upward trend.

Inflation and deflation represent basic concepts for expressing price changes over time. The U.S. experienced high inflation during the 1970’s. After moderating significantly in the early 1980’s, inflation has been fluctuating around 2-3% ever since. Due to inflation, more dollars are required today when purchasing similar goods. Japan’s inflation rate was not nearly as high in the late 70’s and over the past two decades has been effectively nil. Recent deflation means Japanese consumers actually requires less yen to purchase similar goods than ten years ago. A rising PPP therefore reflects today’s need for fewer yen and more dollars to purchase similar goods compared to several decades ago..

Recognizing that changes in PPP have been relatively small and consistent, one might question the more sizable variations in market exchange rates between these currencies. Simply put, short-term movements likely reflect changing opinions about each nation’s future inflation. Displayed clearly above, similar to other financial markets, opinions are volatile but tend to fluctuate around an underlying equilibrium. Today’s stronger yen therefore depicts a belief that future U.S. inflation will be significantly greater than inflation in Japan.

Japan has been mired with slight deflation for the past decade, despite record low interest rates. Monetary experimentation and occasional fiscal stimulus have been unsuccessful to date. Although other stimulative options exist, desire for such policies appears weak, leaving the current status quo as the most probable outcome. Given Japan’s unchanging outlook, recent changes in the exchange rate appear more indicative of updated opinions on future U.S. inflation. Fearing deflation, the Federal Reserve has already embarked on two exercises in quantitative easing, with potential for a third looming. Operationally these measures were merely an asset swap between the Fed and banks aimed at lowering interest rates and increasing asset prices. However, market participants largely believe quantitative easing is a form of printing money that will eventually lead to surging inflation. Expectations of further quantitative easing may therefore account for continued weakening of the dollar.

Along similar lines, I’ve recognized an interesting dichotomy in market opinion with regards to quantitative easing. As previously noted, the Fed’s decision to purchase large quantities of treasury notes has seemingly led increasing inflation expectations and a weakening dollar. Just yesterday, on the other side of the Atlantic, the European Central Bank (ECB) announced it would intervene in debt markets by buying Italian and Spanish sovereign debt. Over the past 18 months, the ECB has made numerous announcements involving their purchase of European sovereign debt. Oddly, these announcements are typically met with a strengthening euro. Below is a graph depicting the dollar/euro exchange rate against a comparable PPP.

Although the dollar/euro exchange rate has experienced wide swings, the PPP has remained fairly constant over the past two decades. Personally, the current euro strength is surprising in the face of ECB intervention and a rapidly deteriorating sovereign debt crisis. Yet considering both market valuations, the most apparent conclusion is that market participants expect much higher relative inflation in the U.S. going forward.

Anytime the market’s prevailing opinion distinctly contradicts your own, a potential investment opportunity arises. Congress’ recent decision to take up austerity measures will likely weaken the economy, causing disinflation. Even if the Fed embarks on a third, similar, round of quantitative easing, the short-term inflationary aspects of rising energy and food prices will create deflationary pressures over a longer period. Regardless of S&P’s U.S credit rating downgrade, the dollar should remain the world’s reserve currency for at least another decade, retaining its safe-haven status in especially uncertain times. Given this outlook, I expect the dollar/yen and dollar/euro to move back towards their PPP over the next few years.



(Note: I tend to disagree with Scott Grannis’ economic and political outlook, especially the last paragraph in the attached blog. However, Grannis often provides interesting data points and graphs making his blog a worthwhile opposing perspective.)

Foreign Income Rising

In Converging on the Horizon (courtesy of John Mauldin), Ed Easterling explains that pre-tax corporate profits as a percentage of GDP are expected to set new record highs in 2012. As reported earnings per share (EPS) are also significantly above normalized EPS based on both Crestmont’s and Shiller’s methodologies. Continuing strength in these figures plays a major role in buoying bullish viewpoints and frustrating bears. Easterling does a wonderful job using historical evidence to support his view that mean reversion of corporate profits is likely nearing. Agreeing with Easterling’s basic outlook, attempting to understand the reasons behind this profit levitation seems a worthwhile endeavor.

Various explanations currently circulate within investment and economic research regarding the superb corporate margins. One theory points to an increasing share of profits accruing to corporations instead of employees. Stagnating wages, a less unionized workforce and regulations increasing barriers to entry all support this notion. Another consideration holds that strong emerging market growth has made up for weak economic growth in developed markets. While probably true to some degree, with U.S., U.K., EU and Japan’s (50%+ of world GDP) growth flat-lining, it’s hard to foresee this trend continuing. A less widely discussed topic deserving attention is the growing percentage of foreign income being deferred from US corporate income taxes.

Over the past several weeks publicly held corporations have been filing their second quarter reports. While firms continue beating expectations at a strong clip (this happens during bear markets too), the reasons behind stronger earnings appear to be changing. During the first portion of this recovery, cost cutting through layoffs boosted margins. As Russ Winter points out in Corporate Tax Avoidance (courtesy of Zero Hedge), diverging effective tax rates are more recently producing larger margins. Just last week Microsoft reported a 7% decline in their effective tax rate as foreign income rose to 68% of the quarter’s total. That’s correct, based on income Microsoft is primarily a foreign company and they’re not alone.

Apple, darling of US investors and techies alike, is only slightly more American than Microsoft. During the most recent quarter, 33% of Apple’s reported income came from the US. The following section from their quarterly filing explains the decrease in effective tax rate (emphasis mine):

“The Company’s effective tax rate for the three- and nine-month periods ended June 25, 2011 was approximately 24%, compared to approximately 24% and 26% for the three- and nine-month periods ended June 26, 2010, respectively. The Company’s effective rates for both periods differ from the statutory federal income tax rate of 35% due primarily to certain undistributed foreign earnings for which no U.S. taxes are provided because such earnings are intended to be indefinitely reinvested outside the U.S..” (Apple, 10-Q, 2nd qtr 2011, p.33)

As stated by Apple, an increasing portion of their earnings are never intended to be reinvested in the U.S. through higher wages, larger dividends or any other manner.

While Apple and Microsoft represent only a minute sample of U.S. corporations, my presumption is that further research focusing on large multinationals will find similar patterns of decreasing effective tax rates and increasing undistributed foreign earnings. For investors, the pertinent question is whether or not effective tax rates will remain or continue moving lower. Investors should also recognize that a significant portion of cash on these companies balance sheets is held abroad and cannot be reinvested in the U.S. without incurring income taxes. A broader concern of this tax policy focuses on its potential long-term economic impact.

In 2004, the U.S. allowed domestic corporations to repatriate undistributed foreign profits at significantly reduced tax rates. Congress hoped this “one-time” tax break would result in firms spending their extra cash to increase domestic jobs. Data largely implies that the special tax break had no visible effect on employment. Unsurprisingly, a more direct effect appears to have been a growing number of firms and percentage of earnings being classified as undistributed foreign profits. With unemployment remaining high, large U.S. multinationals are once again pressing Congress to allow repatriation of foreign profits at a minimal tax rate (5%). Despite historical evidence, several Democrats have supported the proposal. As companies become more confidant in another “one-time” tax break, undistributed foreign profits may experience another surge.

Congress is currently struggling to compromise on a debt limit deal that cuts future spending and reduces deficits for the next decade. Given this debate, a good question regarding corporate taxes would be “why are domestic companies allowed to avoid corporate taxes with undistributed foreign profits?” Jesse’s Café Américain (courtesy of The Big Picture) directs us to ten charts from the Center for American Progress displaying the vast decline in corporate tax revenues:



Corporate tax revenue this year (1.3% of GDP) is near all time lows despite record corporate profits and a supposedly uncompetitive corporate income tax rate of 35%. As chart 9 shows, the effective tax rate for U.S. corporations is only 13.4%, well below most OECD countries. Tax breaks and loopholes not only reduce tax revenue, but heavily favor large corporations. Rather than consider more tax breaks, Congress would be well advised to focus on corporate tax reform.

Corporate tax reform that eliminates breaks and loopholes, while reducing rates, holds the key to several issues plaguing Congress and the current administration. Small businesses, which typically create the most new jobs, will benefit from lower tax rates. Federal tax revenue will increase as far greater sums of income are taxed. Consumers will likely benefit as increased business competition drives down prices and encourages innovation. Although this idea seems simplistic, it has a unique benefit of being both a market-oriented solution (for the right) and more progressive tax system (for the left).

Unfortunately these type of drastic overhauls rarely occur outside a crisis and are in direct opposition of numerous parties with invested interests (as well as significant cash to spend on lawyers and political contributions). Regardless, moving in the opposite direction by allowing another “one-time” tax break is almost certain to hurt economic growth, employment and federal debt in the long run. Hopefully after the senseless debt limit debate ends, the country will begin discussing more valuable issues including tax reform.  

Basic Math Predicts EU Defaults

In his weekly market comment, John Hussman (Hussman Funds) explains why the “Simple Arithmetic” of European sovereign debt forecasts necessary defaults. Hussman demonstrates the severely large portion of Greek GDP simply used to pay interest on sovereign debt given current outstanding amounts and interest rates. While some form of Greece default is now widely accepted, the size of outstanding Italian debt makes it increasingly clear how close interest rates are to rendering principal repayment nearly impossible. Italy announced today that it would forgo planned debt issuance in August due to concerns about prevailing market rates. If interest rates remain heightened in September, we could be looking back on July as the last time Italy had access to credit markets.

Despite focusing on Europe in this week’s comment, Hussman makes a very poignant remark about the maturity of outstanding US debt. Hussman states “it's precisely that short average maturity that makes the debt problematic from a long-run perspective, because it can't be inflated away easily. In the event of sustained inflation, the debt would have to be constantly refinanced at higher and higher yields. Contrary to the assertion that the U.S. can easily inflate its debts away, it is clear that sustained inflation would create enormous risks to our long-run fiscal condition by driving interest costs to an intolerable share of revenues.”

Recent efforts by the Fed through quantitative easing have further shortened the average maturity of outstanding debt. Regardless, many economists and investors argue for betting on long-term inflation because of the US debt burden. As Hussman makes clear, unless the US actively extends the maturity of outstanding debt, attempts to inflate away the problem will more likely exaggerate the risks.

Personally I remain of the view that US inflation is likely to be subdued (below 2%) for several years, with greater potential risk of deflation than high inflation. Long-term treasuries therefore remain a good value at current yields (4.3%) for investors with 3-5 year time horizons.